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Inflation Expectations, the , and the Fed’s Dual Mandate

Jane Ihrig, Ph.D., and Senior Adviser, Board of Governors of the System Ekaterina Peneva, Ph.D., Economist and Chief, and Section, Board of Governors of the Federal Reserve System GLOSSARY Scott Wolla, Ph.D., Economic Coordinator : A general, sustained downward movement of prices for and services in an . Federal Open Committee (FOMC): “There was a time where there was a tight connection between A Committee created by law that consists and . That time is long gone.” of the seven members of the Board of —Jerome Powell, Chair of the Board of Governors of the Federal Reserve System1 Governors; the president of the Federal Reserve of New York; and, on a rotating basis, the presidents of four other Reserve . Nonvoting Reserve Introduction Bank presidents also participate in Committee deliberations and discussion. The Federal Reserve, the of the , has a dual Congressional mandate—to promote maximum and Inflation: A general, sustained upward movement of prices for goods and stability. While these goals were articulated in 1977, the strategy to meet services in an economy. these goals has changed over time. In fact, as recently as 2020, the Federal Inflation rate: The percentage increase in Committee (FOMC), the Federal Reserve’s ­ the average of goods and making body, provided an updated statement on its strategy that included services over a period of time. some adjustments in its plans to pursue price stability. Here we take a look inflation: A general, sustained upward at what pursuing stable prices means, how inflation has evolved over time, movement in the average level of wages. how the connection between inflation and the real economy has changed over time, and what the Federal Reserve (Fed) has said recently about its plan to meet this part of its mandate.

Price Stability: One Side of the Dual Mandate Price stability does not mean that the optimal rate of inflation is zero. The Fed, for example, judges that a moderate, stable, and positive rate of inflation is most consistent with its price stability mandate. Many other central banks around the world also aim for moderate positive rates of inflation in their countries. Why do central banks target positive rates of inflation? First, they want to avoid deflation, a general and persistent decline in the level of prices. Since inflation, even when fairly stable, inevitably fluctuates around some level (sometimes a bit higher and sometimes a bit lower), aiming for a moderate positive rate of price increases helps protect the economy from periods of deflation. Deflation is a phenomenon last experienced during the of the . At that time, deflation led house­ holds to delay making purchases in anticipation of lower prices in the

Summer 2021 of St. Louis | research.stlouisfed.org PAGE ONE Economics® Federal Reserve Bank of St. Louis | research.stlouisfed.org 2 future, and this action put pressure on producers to cut inflation rate will be a function of the specific goods and wages or or both. These deflationary factors put services that are included in the market basket. So it fol­ severe strains on the economy and are a key reason the lows that including a different set of Fed aims for a positive rate of inflation. in the market basket will result in a different overall infla­ tion rate. Probably the most often-discussed inflation Another reason central banks aim for positive rates of measure in the United States is one based on the con­ inflation is to help them conduct monetary policy effec­ sumer price (CPI). The CPI is widely used as a cost-of- tively. When inflation is very low, rates also tend living index to adjust Social Security and other payments. to be very low, even in good times. When an economy A second measure that is frequently watched is the per­ weakens, perhaps goes into a , a central bank sonal consumption expenditures (PCEPI). In will normally reduce interest rates to encourage spend­ January 2012, when the FOMC announced for the first ing and by and businesses. But time a numeric inflation objective, it specified a 2 percent if interest rates are already very low going into the reces­ inflation target for the PCEPI as the inflation rate most con­ sion, the central bank does not have much room to reduce sistent with its Congressional mandate of price stability interest rates to help stimulate the economy. Though and maximum employment. The FOMC chose the PCEPI central banks have other tools to help with monetary over the CPI, in part, because it includes a broader set of policy, the raising and lowering of interest rates is a goods and services in its market basket and is believed known and somewhat precise tool that has been used to better capture changes in consumer behavior. for decades. As seen in Figure 1, the CPI and PCEPI inflation rates Price stability does not mean any positive rate of inflation. move up and down together. During the period known As we just noted, inflation that is too low is close to as the Great Inflation (1965-82), both inflation measures deflation and may not allow a central bank to support a increased sharply. Since this period, the rate of inflation weakening economy. Conversely, inflation that is too has been more moderate. Though similar, the two esti­ high means that the of the dollar mates differ slightly. Over the past 20 years, CPI inflation erodes very quickly, which disproportionately affects averaged 2.0 percent, while PCEPI inflation averaged 1.8 lower-income families and older citizens on fixed incomes. percent—a 0.2 percentage point difference. Some reasons Furthermore, both deflation and too-high inflation can the rates differ include somewhat different baskets of lead to and to spending and decisions goods and services, different prices for some items, and that do not support the best economic outcomes. Reflect­ different weights used to aggregate the items. ing these tradeoffs, central banks have chosen target levels or target ranges for moderate and stable rates of The Phillips Curve: The Changing Relationship Between inflation; this way, households and businesses can make Inflation and Employment informed saving and investment decisions without A key to understanding the Fed’s dual mandate is con­ worrying about the possibility of sustained deflation or sidering how inflation relates to economic activity. One sustained high inflation. frequently mentioned link is the tradeoff between inflation In the United States, the FOMC aims for 2 percent infla­ and unemployment. In the late 1950s, William Phillips tion over time. In the FOMC’s judgement, 2 percent pro­ documented a negative relationship between wage vides a healthy compromise—high enough to provide a inflation and unemployment in the , meaningful buffer from deflation while minimizing the as illustrated in Figure 2. The bottom right of the curve distortions that arise from high inflation. captures data from a weak economy—when unemploy­ ment is high and wage inflation is low. This is most likely Inflation Data to occur during a recession. Here, resources such as labor So how do we go about measuring inflation? The overall are underutilized; you might say there is “slack” in the inflation rate is measured as the rate of increase in the economy. In this situation, many workers are looking for average price level of a broad group of goods and ser­ jobs, and companies do not have incentives to raise wages vices (called a “market basket”). As such, the reported much (if at all) to attract or keep workers. Conversely, the PAGE ONE Economics® Federal Reserve Bank of St. Louis | research.stlouisfed.org 3

Figure 1 Measures of U.S. Inflation

NOTE: The green line at 2 percent starts at January 2012, reflecting when the FOMC began aiming for 2 percent PCEPI inflation over the longer run. SOURCE: FRED®, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/graph/?g=AIo2. top left of the curve—where wage inflation is high and Figure 2 unemployment is low—reflects an economy that is run­ The Traditional Phillips Curve ning hot, perhaps having been expanding for a number of years. Here the labor market may be considered tight, with most people having jobs. In such an economy, firms looking for more workers must compete with each other by significantly boosting wages or offering better benefits to lure them from other opportunities. This is a situation where unemployment is low and wage inflation is high. Since labor costs represent about two-thirds of firms’ total cost of production, they are very important for firms’ pricing decisions. By the mid-1960s, and had noted a similar relation­ ship in the United States between price inflation and unemployment that we now typically refer to as the tra­ ditional “price Phillips curve” or simply the “Phillips curve.” As seen in Figure 3A, U.S. data from the 1960s illustrate the standard price inflation-unemployment curve well. Thus, the Phillips curve captured a tradeoff that policy­ SOURCE: Federal Reserve Bank of St. Louis; https://www.stlouisfed.org/open- vault/2020/january/what-is-phillips-curve-why-flattened. makers considered when setting monetary policy: They could pursue an economy with lower unemployment if they were willing to accept higher inflation. Conversely, if policymakers wanted to pursue lower inflation, they would have to accept higher unemployment and lower economic activity. PAGE ONE Economics® Federal Reserve Bank of St. Louis | research.stlouisfed.org 4

Figure 3 Inflation and Unemployment Inflation Expectations

A. Phillips curve, 1960s Inflation expectations are just what they sound like—expecta­ tions that households and businesses have about future inflation. Inflation expectations are important because they influence peoples’ decisionmaking today, which then impacts future infla­ tion. For example, if a firm expects 2 percent inflation this year and going forward, it will feel comfortable raising the price of its products by about 2 percent, be willing to increase the wages of its workers by about 2 percent to compensate for higher prices (all else equal), and contemplate investment and hiring decisions based on these expectations. Consumers will anticipate prices and wages to increase by about 2 percent and will make their spending and decisions accordingly. And if households and businesses expect 2 percent inflation, and make decisions based on those expectations, their actions contribute to the realization of a 2 percent inflation. With these situations in mind, the FOMC has stated that it aims to “anchor” inflation expecta­ tions at its 2 percent longer-run inflation goal. That way, the Fed’s monetary policies and the expectations of households and firms can reinforce each other. B. Phillips curve, The Fed monitors inflation expectations using data from a wide variety of surveys and from financial instruments. These data differ along several key dimensions, including the horizon of the expectation and the associated measure of inflation. Recently, economists at the Fed constructed an index of common inflation expectations using 21 of these measures. The index captures the general trajectory of many of the long-horizon inflation expectation indicators.

NOTE: A summary of the index of common inflation expectations is found here: https://www.federalreserve.gov/econres/notes/ feds-notes/index-of-common-inflation-expectations-20200902. htm. Updates can be found here: https://www.federalreserve. gov/econres/notes/feds-notes/index-of-common-inflation-ex­ pectations-accessible-20200902.htm.

accept higher inflation. That is, the long-standing pre­ sumption that monetary policy should be tightened as SOURCE: FRED®, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/ unemployment falls to low levels to head off high infla­ graph/?g=BvuJ (panel A); https://fred.stlouisfed.org/graph/?g=BvsW (panel B). tion is no longer how policymakers necessarily think and act. Today, policymakers are willing to allow employment However, this tradeoff has weakened. As recently noted to expand as long as inflation expectations are anchored by Fed Chair Powell, “Inflation has been much lower and around the FOMC’s 2 percent target.3 (See boxed insert, more stable over the past three decades than in earlier “Inflation Expectations.”) In light of these issues, the Fed times.”2 This fact has occurred despite big fluctuations has adjusted its strategy for achieving price stability. in unemployment. As shown in Figure 3B, over the past 20 years, there has not been a strong relationship between Fed’s Actions To Achieve Stable Prices inflation and unemployment. This evidence has led econ­ Each year the FOMC releases a Statement on Longer-Run omists to say that the Phillips curve has flattened. Policy­ Goals and Monetary Policy Strategy. This statement is makers recognize this flat Phillips curve, which allows intended to help the public understand how the Com­ them to pursue lower unemployment without having to mittee aims to achieve its Congressional mandate of PAGE ONE Economics® Federal Reserve Bank of St. Louis | research.stlouisfed.org 5 price stability and maximum employment. Three import­ ant points regarding price stability in the statement What Is “Transitory” Inflation? include the following: Monetary policymakers have a mandate to promote price sta­ bility in the economy, which the FOMC defines as inflation that • The Committee’s longer-run goal for inflation, as averages 2 percent over time. This definition means the Fed measured by the annual change in the PCEPI, is won’t react to every bump or dip in inflation. Rather, the Fed 2 percent. wants to see if a given change in the price level signals transi­ tory or persistently higher or lower future inflation. Transitory • Longer-term inflation expectations that are well inflation is a -lived, or temporary, increase in inflation with anchored at 2 percent are desired to achieve the the expectation that inflation will return to a lower level not Committee’s Congressional mandate of maximum too far in the future. This might occur for a couple of reasons. employment and price stability. First, inflation is often measured as a 12-month change, so it’s calculated as a percent change between two index number • To anchor longer-term inflation expectations at that are 12 months apart. If the price index fell 12 months ago, 2 percent, the FOMC will seek to achieve inflation as it did in Spring 2020 when the COVID-19 outbreak halted many activities, the calculations a year later would show extra that averages 2 percent over time. inflation because the level a year ago was temporarily low. This The first of these points reiterates to the public that the is what’s often called base effects. Of course, that low level will “fall out” of the calculation window as time moves on. Hence, explicit price measure the FOMC uses to measure inflation the higher inflation readings will be (all else equal) short-lived, is the PCEPI and that it plans to achieve inflation that not a sign of persistently high inflation. Another example is a averages 2 percent over time. The second point is not bottleneck, which is a temporary blockage or restriction in the only that the FOMC cares about current inflation, but also supply chain. Think of the supply chain disruptions that can result from an event like a storm or pandemic. These events that the public has expectations for inflation consistent might cause an increase in the prices of key goods and services with the FOMC’s 2 percent inflation goal. The FOMC that show up in the inflation numbers, but it will likely be short- believes that inflation expectations anchored at 2 percent lived as workers and businesses recover and adapt. The import­ ant point to remember is that the Fed intends to adjust the will help it achieve its dual mandate. Finally, given that stance of monetary policy in response to persistently high or inflation tends to move up and down over time, in 2020 low inflation, especially inflation that moves inflation expecta­ the FOMC adjusted its statement on longer-run goals to tions away from 2 percent. emphasize that it’s looking for inflation that averages 2 percent over time. The Committee believes that “by seeking inflation that averages 2 percent over time this these price increases were reflecting transitory factors. will help ensure longer-run inflation expectations do not (See boxed insert, “What Is ‘Transitory’ Inflation?”) The drift down and remain well anchored at 2 percent.”4 This FOMC also indicated that it is aiming to achieve inflation approach has been referred to as a flexible average infla- moderately above 2 percent for a bit of time so that tion target (FAIT) policy. FAIT means the inflation goal is inflation averages 2 percent over time, consistent with symmetric around 2 percent, which means that some­ its FAIT policy. In addition, given that the Phillips curve times inflation may be a bit above 2 percent and at other is quite flat, there does not seem to be a strong “tradeoff” times may be a bit below 2 percent; but, on average, it between raising inflation and overheating the labor mar­ should be 2 percent. ket. This means that policymakers can aim for both further improvements in the labor market and moving inflation Going Forward above 2 percent, so long as inflation expectations are consistent with the long-run 2 percent objective. n After running persistently below 2 percent for nearly a decade, inflation moved up above 2 percent in the first half of 2021. In response, the FOMC stated that it believed PAGE ONE Economics® Federal Reserve Bank of St. Louis | research.stlouisfed.org 6

Notes 1 See the transcript of Chair Powell’s Press Conference, March 17, 2021; https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20210317.pdf. 2 Powell, Jerome. “Getting Back to a Strong Labor Market,” at the Economic Club of New York. Board of Governors of the Federal Reserve System, February 10, 2021; https://www.federalreserve.gov/newsevents/speech/powell20210210a.htm, accessed , 2021. 3 If households anticipate that policymakers are attempting to achieve per- sistently lower unemployment by being willing to accept potentially higher inflation, households may begin to expect higher inflation. In this case, they will build these expectations into wage and price decisions. This, in turn, will lead to higher inflation for any rate of unemployment. How this would actually play out in today’s environment with the weakened tradeoff is uncertain, but this is an issue that policymakers must evaluate as they determine optimal policy. 4 Board of Governors of the Federal Reserve System. “Q&As: Has the Federal Reserve’s inflation objective changed? Why is the Federal Reserve interested in achieving inflation that averages 2 percent over time?” https://www.federalreserve.gov/monetarypolicy/review-of-monetary-poli- cy-strategy-tools-and-communications-qas.htm#7, accessed May 4, 2021.

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Federal Reserve Bank of St. Louis Page One Economics®: “Inflation Expectations, the Phillips Curve, and the Fed’s Dual Mandate”

After reading the article, answer the following questions: 1. Deflation occurs a. frequently; it occurs whenever the prices of some goods and services decrease. b. rarely; the last time it occurred was during the Great Depression of the 1930s. c. rarely; the last time it occurred was during World II. d. rarely; the last time it occurred was during the Civil War.

2. The Fed prefers to target a positive rate of inflation because a. the Fed wants to keep inflation high to keep unemployment low. b. the Fed keeps inflation high to benefit those with high . c. the Fed target is flexible as long as the inflation rate is a positive number. d. the Fed wants some inflation to provide a buffer from deflation.

3. Which measure of inflation does the FOMC specify as its inflation target? a. Consumer price index (CPI) b. Core consumer price index (core CPI) c. Personal consumption expenditures price index (PCEPI) d. GDP deflator

4. The Phillips curve shows the relationship between a. inflation and unemployment. b. inflation and . c. unemployment and economic growth. d. inflation and savings.

5. What “tradeoff” did policymakers infer from the U.S. Phillips curve that used data from the 1960s? a. They could pursue an economy with lower unemployment if they were willing to accept lower inflation. b. They could pursue faster economic growth rates if they were willing to accept higher unemployment. c. They could pursue higher standards of living if they were willing to accept higher unemployment. d. They could pursue an economy with lower unemployment if they were willing to accept higher inflation. PAGE ONE Economics® Federal Reserve Bank of St. Louis | research.stlouisfed.org 8

6. What has happened to the Phillips curve in the past 20 years? a. It has flattened; unemployment has remained low even when there have been large fluctuations in inflation over time. b. It has flattened; economic growth has remained low even when there have been large fluctuations in unemployment over time. c. It has flattened; inflation has remained low even when there have been large fluctuations in unemployment over time. d. It has steepened; inflation has become even more sensitive to changes in unemployment.

7. What are the implications of having inflation expectations that are “firmly anchored” at 2 percent? a. Households and firms will try to take advantage of low inflation by increasing their spending, which will push the inflation rate above the Fed’s inflation goal. b. People will act in such a way that the anchor becomes detached, and the economy will fall into deflation. c. People will act in such a way that causes the anchor to become detached, and inflation will rise and become more volatile. d. People will make decisions assuming inflation will continue to be 2 percent in the long run, even if inflation runs below or above that level at times.

8. How did the Fed’s 2020 Statement on Longer-Run Goals and Monetary Policy Strategy clarify the Fed’s price stability goal? a. The goal is a 2 percent ceiling, which means the Fed should not allow inflation to rise above 2 percent. b. The goal is a 2 percent floor, which means the Fed should not allow inflation to fall below 2 percent. c. The goal is inflation that averages 2 percent over time, which means inflation will be both above and below 2 percent at times. d. The goal is to keep inflation as close to zero as possible to ensure that inflation does not erode the purchasing power of .

9. Why is the FOMC more concerned about persistent inflation rather than transitory inflation? a. Transitory inflation is likely due to short-lived effects such as a supply chain bottleneck that will be corrected as workers and businesses react. b. Transitory inflation is likely due to the Fed using monetary policy tools to push unemployment down, which is worth the tradeoff. c. Persistent inflation is short-lived, and therefore its effects are not concerning to policymakers. d. Persistent inflation will likely be short-lived as numbers “drop out” of the year-over-year calculations.

10. What are the implications of the current shape of the Phillips curve? a. The FOMC can pursue an economy with lower unemployment, but only if it is willing to accept higher inflation. b. The FOMC can pursue an economy with lower inflation, but only if it is willing to accept higher unemployment. c. The FOMC can pursue an economy with lower unemployment, with less concern about rising inflation; the “tradeoff” has weakened. d. The FOMC no longer pursues an economy with lower unemployment, fearing a persistent rise in inflation; the “tradeoff” has strengthened.